The sharp slowdown in trading volumes over the past two months is threatening to undermine the recovery in investment banking and capital markets this year and is challenging the model that many banks have adopted in response to the financial crisis.

A drop of about 40% in trading volumes across asset classes last month and low capital markets activity are resetting earnings expectations for the rest of the year.

When derivatives broker Icap last week reported a “sharp slowdown” in volumes across markets in June, it wiped nearly 5% off its share price.

The head of corporate and investment banking at a large European bank said the news from Icap was a “worrying lead indicator”. He said: “One of my biggest concerns is that we see a sustained flatlining of trading activity over the next six months.”

These concerns were stoked last week when JP Morgan, Bank of America Merrill Lynch and Citigroup reported second-quarter declines in sales and trading revenues compared with the first three months this year and in the same period last year.

The growing fear in the industry is that the poor earnings environment could continue longer than investment banks can afford with their existing cost structures.

Brad Hintz, banks analyst at Sanford C Bernstein, warned that it could be the fourth quarter before trading volumes recover. “Investors in Europe and the US have been frozen in place like deer in the headlights by the high volatility,” he said. “This is an unpleasant period.”

Trading volumes fell sharply in June after a volatile May. Trading on Icap’s EBS and BrokerTec platforms tumbled 30% from May levels while derivatives trading on NYSE Liffe dropped 71%.

The European head of fixed income at a European bank blamed uncertainty over regulatory action for the decline in trading volumes, and added: “The market doesn’t know how to trade politics.”

Investors and investment banks are awaiting the outcome of proposals by legislators and regulators in both Europe and the US.

One reason for the fall in trading volumes is that investors are increasingly risk-averse and are holding cash at their highest levels since March 2009. More than a third of those polled in Bank of America Merrill Lynch’s fund manager survey this month said they were overweight cash in their portfolios, compared to 29% in June and 9% in May.

Banks refocused on client business last year after many of them wound down their proprietary trading activities. With fewer proprietary trading desks and hedge funds driving volumes, this has left many banks more exposed to changes in investor sentiment and flow business, and has coincided with a drop in deal activity.

The value of debt issues globally in the second quarter was 34% lower than the first quarter, and May was the quietest month for debt issues since November 2008, according to Dealogic. Second-quarter equity issuance was at its lowest level since 2005.

Hintz, previously treasurer at Lehman Brothers, warned that a drop in liquidity had ripple effects of impacting both sales and trading revenue as prop trading became more difficult in thinner markets. This would in turn affect equity derivatives as their hedges would work less efficiently in an illiquid market, prompting management to slash risk, Hintz added.

Nick Finegold, chief executive of Execution Noble, the investment bank, said: “Part of it is that leverage in the system is not there, part of it is that capital adequacy is more stringent, part of it is that people post the credit crunch are more conservative, the stars of the credit crunch have had a more conservative approach and performance has been very difficult.”